NUST JOURNAL OF SOCIAL SCIENCES AND HUMANITIES

Vol.5 No.1 (January-June 2019) pp. 43-62

The Current Model of Islamic Banking and Concentration

of Wealth

Waqasul Hassan* and Anwar Shah†

Abstract:

The eradication of the concentration of wealth is one of the prime objectives

of Islamic finance. Many scholars have written on this issue, who claim that by

eradicating interest from the society, we will be able to minimise the concentration of

wealth in an economy. This study conjectures that interest-free finance is a necessary

but not sufficient condition for the eradication of concentration of wealth. The sufficient

condition is to bring change in the objective of the Islamic banks that is, switching the

moto from the maximisation of the profit to the maximisation of welfare of society. This

paper states that the main focus of Islamic banks is to transform the current models of

interest based transactions to interest free transactions. However, merely changing the

transactions from interest based to interest free might not be enough to achieve the

main objective of Islamic finance. The study compares the assets side of Islamic and

conventional banks to provide support in favour of the hypothesis that with current

objective of profit maximisation, the Islamic banks are less likely to play any role in the

eradication of the concentration of wealth.

Keywords: Circulation of Wealth, Islamic Finance, Participatory

finance, Interest rate.

1. INTRODUCTION

Wealth plays a key role in the development of an economy.

However, it is not the production of wealth that matters; it is the

circulation of wealth that is important for an economy. For this purpose,

conventional economics has developed a financial system to ensure the

circulation of wealth within an economy [Mishkin (2004)]. The main

objective of such financial system is to ensure the channelisation of

money from surplus unit (savers) to deficit units (Investors). Such

channelisation takes place either directly through money and capital

markets or indirectly through financial intermediaries such as banks etc.

* Waqasul Hassan <waqas.hassan92@hotmail.com> is Graduate, School of

Economics, Quaid-i-Azam University, Islamabad, Pakistan. † Anwar Shah <anwar@qau.edu.pk.> is Assistant Professor, School of Economics,

Quaid-i-Azam University, Islamabad, Pakistan.

44 Hassan and Shah

The main lubricant for the flow of money from the surplus unit

to the deficit unit in the conventional financial system is interest. Banks

pay interest to depositors and receive interest from investors. One of the

main outcomes of interest based financial system is the concentration of

wealth in economies. The reason is that funds are not allocated on the

basis of productivity in economy; rather it is allocated on the basis of

credit worthiness. Hence, large corporations and businesses enjoy access

to funds and earn billions. New but productive investors are denied

access as they do not have collaterals. Thus, interest based financial

system is structurally flawed to solve the issue of the concentration of

wealth.

Is there any solution of this issue of the concentration of wealth?

The answer is yes provided that interest is declared illegal. In this regard,

economic system based on the tenants of Islam provides an ideal solution

for the problem of concentration of wealth. First, Islam declares interest

illegal.1

Next, Islam provides a comprehensive alternative for the flow of

money from savers to investors without interest. These alternatives are

in the form of three main modes of financing. The first alternative is trade

based and includes “Murabaha” “Bai Salam” and “Bai Moajjal”. The

second alternative is leasing based, mainly including “Ijara” and the

third alternative is participatory based, that includes “Mudharabah” and

“Musharkah”.

Based on the tenets of Islam, a large industry has emerged in the

world in general and Islamic countries in particular to provide Islamic

finance in the market. Pakistan has also initiated Islamic finance since

1979 and was among the first three countries with interest free banking.

However, the system could not move successfully due to lack of sharia

guided rules, proper homework at the level of central bank and

1 The Holy Quran in four different places (surah) mentions the prohibition of interest

(Riba). Surah Al-Rum, verse 39, Surah Al-Nisa', verse 161, Surah Al 'Imran, verses

130-32 and Surah al-Baqarah, verses 275-81. Likewise, different sayings of the Holy

Prophet Muhammad (PBUH) mention the prohibition of interest: For example, as

Hazrat Jabir (RA) states that The Prophet (PBUH) cursed the receiver and the payer of

interest; the one who records it and witnesses of the transaction and said: "They are all

alike [in guilt].

The Current Model of Islamic Banking 45

unacceptability of sudden shifts for banks from conventional to Islamic

modes.2

Hence, Islamic banking was re-launched in Pakistan in 2001 after

removing the above mentioned deficiencies by the Government of

Pakistan. For this purpose, Islamic banking department in State Bank of

Pakistan (SBP) was established in 2003. This department aims to

enhance and strengthen sharia compliance finance in Islamic Banks.

Over time, five full-fledged Islamic banks and fourteen conventional

banks with Islamic banking branches started operating in Pakistan.3

It is pertinent to mention that the main mode to ensure the

circulation of wealth in Islam is participatory based financing that is

“Mudharabah” and “Musharkah”. The reason is that it leads to effi-

ciency as well as equity, simultaneously. Efficiency comes as in

participatory financing funds transfer from one person to another based

on productivity and not on the basis of creditworthiness leading to

increase in the level of production of wealth. Equity comes as both

parties distribute profit according to the predetermined agreed ratio.

Moreover, in case of loss both bear the loss and economy is relieved from

passing the responsibility to other people in society. Nevertheless,

Islamic finance industry prefers sale based transaction and that too

“Murabaha” instead of doing participatory based financing. The data

show that the share of Mudharabah has decreased while that of the share

of Murabaha has increased over time in the Islamic banking industry

within Pakistan and across the world (see for example, Islamic Banking

Bulletin by State Bank of Pakistan). Hence, one can claim safely that

Islamic banks are playing very passive role in minimizing the

concentration of wealth within an economy.

Why is this the case? Some scholars have highlighted the reasons

that why Islamic banks is not playing a role in minimizing the

concentration of wealth. For example, Razi (2014) reports that the lack

2 State Bank of Pakistan (http://www.sbp.org.pk/departments/ibd.htm). 3 List of full-fledged Islamic Banks are: Meezan bank, Al Barakah Islamic Bank, Bank

Islamic, Dubai Islamic bank and Burj Bank limited. While the list of banks with Islamic

braches are: Habib Bank, Askari Bank, National Bank of Pakistan, Muslim Commercial

Bank, United Bank Limited, Bank Al-Habib, Dawood Islamic Bank Limited, Standard

Chartered Bank, Emirates Global Islamic Bank, Bank Al-Falah., Summit Bank, Bank

AL-Habib Limited, The Bank of Khebar.

46 Hassan and Shah

of regulations for Islamic banking in Muslim countries is playing a role

in the concentration of wealth. Dar and Presely (2000) show that agency

problem, lack of property rights, and tough competition from conven-

tional banks determine this failure. Abdul and Sarker (1999) considers

the issue of principle agent as the major cause of the low level of

participatory financing. However, to our knowledge researchers have

given little attention to the motive of profit maximization of banks as one

of the possible factors in the concentration of wealth. In this paper we

aim to fill this research gap.

This study adds in the current literature in the sense that the

motive of profit maximisation in Islamic banks herself is the main reason

for the concentration of wealth. We are of the view that Islamic finance

industry has entered the market with the objective of profit maxi-

misation. Hence, there is no difference in the objective of conventional

and Islamic banks. The only difference is that conventional industry does

not take into account the compatibility of any modes with Islamic

teaching while the latter tries to give due regard to Islamic teachings.

However, Islamic banks are making pick-and-choose policy in the

available modes of Islamic financing and mostly choose the one with the

high probability of profit and low level of risk. Therefore, they mostly

pick sale-based financing and leave participatory-based financing.

In order to pursue the motive of profit maximisation on average

each Islamic bank tries to make contract with financially sound and

strong organizations. They are ready to enter into participatory financing

with such organisations. But the profit motive of such organisations

requires to avoid sharing profit with Islamic Banks. So they prefer fixed

return-based financing. On the other hand, the profit motive of

financially weak organization requires that they should enter into

participatory-based financing with Islamic banks but the profit motive of

Islamic Banks requires to enter into low risk sale- based transaction with

them. Hence, the profit motives of Islamic Banks do not allow them to

minimise the concentration of wealth. In this paper we set out to test

whether such outcomes of profit motives is supported by data. In other

words we want to know whether sound organisations/firms prefer fixed

return-based financing while weak organisations/firms prefer participa-

tory-based financing.

The Current Model of Islamic Banking 47

To test our hypothesis, we collect data from firms in Pakistan.

We collect data regarding assets and profit after tax from the annual

reports of firms. While, information regarding willingness for taking

partnership or sale-based finance from Islamic banks is collected through

telephone. We mainly test that the firms with higher level of profits will

prefer non-participatory based financing with Islamic banks. On the

other hand, firms with low level of profits will prefer participatory-based

financing with Islamic banks. However, the data we collected partially

support this hypothesis. We find that large corporations are willing to

enter into participatory-based financing with Islamic banks. The prob-

able reason, we found, on the basis of our telephonic interview is that

Islamic banks offer high share in the profit to them. The study suggests

that Islamic banks can engage large corporations only if it sacrifices

some fraction of its profit. The limitation of the study is that we could

not test the hypothesis for small corporations and businesses. We divide

the registered companies on the basis of profit level into large and small,

which is not a very objective criterion for dividing the firms into strong

and weak. Future research can test our hypothesis with rich data.

The rest of the paper is organized as follows: Section 2 discusses

literature review. Section 3 describes theoretical framework and

hypotheses. Section 4 explains data and model, Section 5 discusses

results, while Section 6 concludes the study.

2. LITERATURE REVIEW

In this section, first we present literature that discusses the reason

of trade-based finance in Islamic banks industry on theoretical basis.

Then, we present some empirical studies, which examine factors

affecting the behaviour of players in Islamic banks industry.

2.1. Theoretical Literature

Interest-bearing system promotes income inequalities and has

detrimental effects on efficiency and growth [Siddiqui, (2004)].

Likewise, it disturbs balance in the society, creates political issues, and

paves way for many extremist theories [Chapra (2008)]. On the other

48 Hassan and Shah

hand profit and loss sharing financial system brings efficiency and equity

in the society. However, Islamic banks rarely follow the modes of profit

loss sharing (PLS). This is inspite of the fact that the pioneers of Islamic

bank clearly mention that the main objective of Islamic banks is to

provide the opportunity of participatory mode of financing to clients [See

for details, Moudoodi (2000), (2002)] What are the reasons of this

theoretical drift? Mughal (2017) provides a comprehensive detail about

such drift. He mentions that over time some scholars start considering

PLS and trade-based financing to be the same. While the pioneers used

to considered participatory finance to be the best and allowed the trade-

based finance in special circumstances, but over the time scholars

provide justification for combining several contracts in one contract to

justify sharia issues in the Murabaha-based finance. In the same manner

Islamic scholars start defending all types of criticism on sale-based

financing [see for example, Ismail (1986), (2001); El-Gamal (2000) for

theoretical justification of sale-based financing]. Hamoud (1982) also

highlights the constraints of participatory financing in the Islamic

banking industry. Haque (1985) provides details on how participatory

financing may provide benefit to one person in case of asymmetric

information. In the same line, Warde (2006) sheds light on the issue of

adverse selection and moral hazard in the participatory mode of

financing. Saeedi (1998) and Usmani (2009) provide justification of

joining more contracts into one contract. The loan created after sale-

based products are paid in installments and assumed tantamount to

interest. However, they are justified on the basis that though such modes

do not equal the ideal of PLS system, yet they serve the needs of real

economy without involving the volatility of conventional interest-based

system because they are based on the sale of real asset [Nienhaus,

(2011)].

Dar and Presely (2000) consider agency problem as one of the

factors for lack of profit and loss sharing in Islamic banking. Likewise,

weak property right in Islamic countries, tough competition from

conventional banks, restrictive role of investor in management, unfair

treatment with PLS in taxation and imbalance in management and

control in PLS are some of the reasons of low level of participatory

financing in Islamic banks. Abdul and Sarker (1999) also consider

The Current Model of Islamic Banking 49

principle agent problem as the major cause of low level of profit loss

sharing finance in Islamic banking. They mention that it is very difficult

for Islamic banks to get true information about borrowers. In the same

way, the issue of moral hazard and adverse selection restrict Islamic

banks to compete with conventional banks.

2.2. Empirical Literature

Kasri and Kassim (2009) provide details regarding how deposits

flow of Islamic banks are influenced by the return on deposits in

conventional banks. They examine the factors that determine saving in

Islamic banks of Indonesia using data from 2000 to 2007. The study

shows that when real rate of return provided by Islamic banks is lower

than the real interest rate provided by conventional banks then people

transfer their funds from Islamic banks to conventional banks.

Rachmawati and Syamsulhakim (2004) also explore the factors

responsible for investment in Mudharabah deposits in Indonesia using

Quarterly data from 1993 to 2003. The study takes the variables of GDP,

profit sharing ratio, interest rate, number of branches of Islamic banks,

and Mudharabah deposits for the purpose of analysis. Cointegration

technique is used to find out long-run relationship between investment

in Mudharabah and other factors. The findings show that the number of

branches of Islamic banks significantly affects Mudharabah deposits in

Islamic banks, while interest rate and GDP do not have significant effect.

Jaffar and Musa (2014) examine the demand of Islamic financing

from halal industry in Malaysia. The findings show that 40% halal

industry were currently using Islamic finance while 60% were non-users.

The reason of the non-user was the absence of knowledge about Islamic

finance. The study shows that 40% respondents had knowledge of

Islamic finance, 10% had partial knowledge while 50% had limited to

zero knowledge about Islamic finance.

To our knowledge, we did not find empirical work that relates

the motive of profit maximisation with the trend of non-PLS transaction

in Islamic banks. Hence, this paper is an effort in this direction. We

examine whether profit maximisation is one of the main motives of low

50 Hassan and Shah

level of participatory financing. We examine this issue from demand

side; i.e., from the actual financial contract of firms with Islamic banks.

3. THEORETICAL FRAMEWORK AND HYPOTHESIS

Profit maximization is the main assumption for theories related

to firms in Economics. In addition, such behavior of firms is considered

important for the allocative efficiency of funds in the market. In this

regard the following quote of Adam Smith (1776) is widely referred.

“It is not from the benevolence of the butcher, the brewer,

or the baker that we expect our dinner, but from their

regard to their own self-interest. We address ourselves not

to their humanity but to their self-love, and never talk to

them of our own necessities, but of their advantages” (Book

1, Chapter 2 Page 2).

Contrary to the above, this study assumes that the objective of

profit maximisation leads to inefficiency in the financial market in the

form of concentration of wealth in an economy. We are of the view that

if firms including Islamic banks pursue profit maximisation in the

market, then the concentration of wealth is inevitable. The contract based

on non-participatory finance with clients symbolizes such a situation.

We explain such an outcome in game theoretic form in Table 1. The table

presents normal form of a battle of sexes game with two players. Player

1 is strong firm while player 2 is Islamic bank. Player 1 prefers the

strategy of Non-PLS, while Islamic bank prefers the strategy of PLS. It

is to be noted that PLS stands for profit-loss sharing contract.

Table 1. Game Theoretic Presentation of the Interaction of Islamic

Banks with Strong Firms

Player 2 (Islamic bank)

PLS Non-PLS

Player 1

(Strong firm)

PLS Low, High Zero, Zero

Non-PLS Zero, Zero High, Low

The Current Model of Islamic Banking 51

The game has two Nash Equilibria. However, theory fails to

predict which Nash Equilibrium will prevail. Nevertheless, behavioural

game theory [Camerer (2003)] suggests that Nash Equilibrium of (Non-

PLS, Non-PLS) will prevail as Islamic banks cannot afford to disappoint

strong firms in the market. They fear that if we will not accept the

demand of strong firms, we might lose a strong customer, which will

transmit negative signals in the markets for other customers and a profit

maximizer firm cannot afford such negative signals in the market.

If we replace player 1 with a weak firm as shown in Table 2, then

Islamic banks are not interested in PLS with such firms. The banks

consider PLS risky with such firms. On the other hand, such firms prefer

PLS with Islamic banks as they think that in case of loss, the banks will

bear all the risk. In such circumstances, the Nash Equilibrium will be

again (Non-PLS, Non-PLS). Here bargaining position of the bank is

strong; hence, its dominant strategy will prevail.

What is the upshot of these two tables? The upshot is that in a

market where profit maximisation is the motive of Islamic Banks, they

will prefer PLS with strong firms, but such firms would not like to share

their profit with Islamic Banks. So the outcome will be No-PLS contract.

Conversely, weak firms would like PLS with Islamic Banks, but the

banks do not want so. Hence, in both situations, there will be non-PLS

equilibrium. Hence, the level of concentration of wealth will not drop

even in the case of Islamic Banks in financial industry. Based on the

above discussion, we make two hypotheses.

Hypothesis 1: Financially sound Profit maximiser firms are less likely to

demand PLS contract from Islamic Banks.

Hypothesis 2: Islamic banks are less likely to offer PLS to financially

weak firms.

52 Hassan and Shah

Table 2. Game Theoretic Presentation of the Interaction of Islamic

Banks with Weak Firms

Modes

Player 2 (Islamic Bank)

PLS Non-PLS

Player 1 (Weak

firm)

PLS High, Low Zero, Zero

Non-PLS Zero, Zero Low, High

4. DATA, VARAIABLES, AND MODEL

To test the hypotheses of the study, we collect data on assets and

profits of the firms in Pakistan. Assets of a firm include current (stock in

investment, short term investment) and non-current assets (plant,

property, equipment). This is collected from annual financial statements

of firms for 2010 to 2013. Profit of a firm includes profit after taxation.

This is also collected from annual financial statements of firms. We

categorize firms into two types: strong and weak. If a firm has average

profit equal or greater than the average of the industry’s profit, we termed

it strong otherwise weak.4 The key variable to test our hypotheses is the

status of current contract between firms and Islamic Banks. This

information is not available through secondary data sources. Hence, we

tried to collect this information through email, but response was very

poor and negligible. Thus, we collected this information through

telephone calls. For this, first, we collect landline numbers of firms from

their website. Next, we contact on phone with CFO (chief financial

officer) of the firm. In case he/she was out of contact, we then contacted

any senior most employees in the finance section of firms. Through this

process, we collected data from 100 firms. After brief introduction

regarding our research work and university, the main question we asked

on phone was: “Has your company ever taken Mudharabah or

Musharakah (Partnership based Islamic) financing from banks (Islamic)

4 This categorization is subjective, we tried to get a cut-off point from literature, but we

could not get any reference. To make the categorization objective we took the average

profit of industry as cut off line. Firms above such line are strong and firms below such

line are weak.

The Current Model of Islamic Banking 53

within last 5 years? 5”. Positive reply of the question was record as 1

otherwise zero.

We want to examine the role of the size of assets and profits on

the decision of firms regarding participatory financing with Islamic

Banks. Hence, dependent variable of the study is whether a firm opts for

participatory financing or not. This is captured through a dummy

variable, which takes the value of 1 for the participatory contract with

Islamic Banks, otherwise zero. Hence, the dependent variable is binary

for which the relevant model is Logit model as shown below:

𝐿𝑖 = ln (𝑃𝑖

1−𝑃𝑖) = 𝑍𝑖= = α + β1(Average asset of firm) +

β2(Average profit after tax) + µ … (1)

where L stands for logit, p is probability of getting PLS facility and 1-p

is probability of not getting PLS facility.

5. RESULTS

5.1. Overview of the Islamic Products in Pakistan

Table 3 provides comparison of various types of financing in the

Islamic Banking industry of Pakistan. The table shows the volume of

trading, Ijara, and participation based financing for the period of 2012 to

2015. The comparison of the data in Table 3 is in line with the hypothesis

of this study that the motive of profit maximisation leads to non-PLS

contracts in the Islamic banking industry. We observe that the share of

Mudharabah financing decreases over time. However, the share of

Musharkah is increasing over time, which is not in line with our

hypothesis. One can ask why the share of Musharakah is increasing over

time as compared to Mudharabah? A probable answer is that the level

of risk in Musharakah as compared to Mudharabah is lower for Islamic

banks. In Musharakah both share capital, hence both (the banks and

investor) share the profit as well as the risk of loss. Though increase in

5 Question is asked about last 5 years just to make it compatible with average of data.

54 Hassan and Shah

the share of Musharakah is appreciable but is less likely to increase the

circulation of wealth.

Table 3. Comparison of Modes of Financing in Islamic Banking Industry

in Pakistan (in billion Rupees) Modes of

Financing

Dec-12 Sep-13 Dec-13 Sep-14 Dec-14 Mar-15 Total

Murabaha 97.5

(39.7%)

112.5

(40.2%)

134.2

(40.6%)

105.7

(30.3%)

127.2

(30.1%)

113.7

(27.09%)

690.8

(33.7%)

Ijarah 22.5

(9.2%)

24.2

(8.6%)

25.4

(7.7%)

29.8

(8.6%)

32.3

(7.7%)

33.1

(7.9%)

167.3

(8.1%)

Musharakah 1.9

(0.8%)

11.6

(4.2%)

22

(6.7%)

35.0

(10.1%)

46.5

(11.0%)

47.6

(11.4%)

164.6

(8 %)

Mudharabah 0.6

(0.2%)

0.5

(0.2%)

0.5

(0.2%)

0.5

(0.2%)

0.2

(0.1%)

0.2

(.04%)

2.5

(0.12%)

Diminishing

Musharakah

(DM)

87.7

(35.7%)

92.6

(33%)

101.8

(30.8%)

122.5

(35.1%)

137.7

(32.6%)

147.9

(35.9%)

690.2

(33.7%)

Salam 7.3

(3%)

9.5

(3.4%)

13.3

(4 %)

9.0

(2.6%)

19.2

(4.5%)

22.3

(5.3% )

80.6

(3.9%)

Istisna 17.7

(7.2%)

13.4

(4.8%)

18.5

(5.6%)

27.5

(7.9%)

35.2

(8.3%)

31.0

(7.4%)

143.3

(7%)

Others 10.5

(4.3%)

15.7

(5.6%)

14.5

(4.4%)

18.4

(5.3%)

23.8

(5.6%)

21.9

(5.2 %)

104.8

(5.1%)

Total 245.7 280.1 330.2 348.5 422.1 417.8 2044.4

Source: Bulletin from Islamic banking department of state bank of Pakistan.

The reason is that the role of Musharakah in decreasing the

concentration of wealth in the hands of few is lower than the role of

Mudharabah. On the other hand, the magnitude of Murabaha is far

greater than the magnitude of Mudharabah, and Musharkah. In other

words, the share of Musharakah as compared to Murabaha is very low.

5.2 Descriptive Statistics

We provide detail regarding ratio of PLS financing in Table 4.

The table shows that 37 out of 100 firms are taking funds from Islamic

The Current Model of Islamic Banking 55

banks on the basis of PLS. However, we find very weak support in favour

of our hypothesis that financially strong firm have non-PLS contract with

Islamic bank. Per data 18/37 (48%) strong firms are doing PLS with

Islamic banks. While 19/37 (52%) are doing non-PLS with Islamic

Banks. What might be the reason of this contradictory result? One of the

probable reasons could be the subjective division of firms between

strong and weak on the basis of annual average profit. It is possible that

whom we consider weak might be strong firms and vice versa. Hence,

we cautiously state that our hypothesis is rejected based on the collected

data

Table 4. Participatory Financing and the Types of Firms

Total Number of Strong

firm6

Number of non-strong

firms

Number of firm 100 27 73

Firms with PLS

financing

37 18

(48%)

19

(52%)

Firms with Non-

PLS financing

63 9

(15%)

54

(85%)

We also find that 63/100 firms are doing non-PLS financing with

Islamic Banks. It is worth mentioning that the average profit of only 9/63

(10%) is more than one thousand million rupees (average profit of the

industry). That is only 9 firms are strong based on the criterion we have

defined. While the average profits of 11/63 (18%) is higher than five

hundred million rupees while the average profit of 46/63 (68%) is less

than three hundred million rupees. This shows that Islamic banks prefer

non-PLS financing with firms who are relatively weak in the market.

One of the possible reasons is non-willingness by Islamic banks to do

PLS financing with weak firms. This reason is supported by one of our

meetings with zonal manager of an Islamic Bank in Pakistan. The main

points of that meeting are:

The process of contract finalization is not simple. The Bank

considers many factors before taking decisions.

6 Mean of average profit is Rs. 800 million rupees.

56 Hassan and Shah

Such process includes checking previous trends in profits and

assets of firm as well as the market share of such firms.

Some procedures of checking the worth of firms are

confidential and are even not disclosed to firms.

The Bank tries to capture well-reputed firms in the market.

5.3 Regression Estimate

Table 5 shows the outcome of the regression based on the

following two regression equations:

𝐿𝑖 = ln (𝑃𝑖

1−𝑃𝑖) = 𝑍𝑖= = α + β1(Log(AST) + β2(Log(AP)) + µ … (2)

𝐿𝑖 = ln (𝑃𝑖

1−𝑃𝑖) = 𝑍𝑖= = α + β1(Log(AST) + β2 (Dummy) + µ … (3)

Table 5. Regression Results

Model 1 Model 2

Marginal effects Marginal effects

log of Assets -0.0209

(.05096)

.0593

(.0376)

Log of Profits 0.1496***

(.04921)

Dummy Variable 0.3034***

(.13004)

Pseudo R2 0.1638 0.1248

AIC 116.203 121.342

AIC and BIC favours first model. *** show significance at 10%.

First, we estimate the regression by including log of profit and

log of assets as independent variables. Second, we include dummy

variable (which is 1 if Average Profits are greater than the mean value,

otherwise 0). In the first model we find that log of average profit is

significant which shows that the probability to choose participatory

financing with Islamic banks increases if log of average profit increases.

If there is one-unit increase in the average profits of firm, then the

probability for adopting participatory financing increases by 14%. This

result is robust as in the second model the coefficient of dummy variable

is also significant. This shows that if a firm surpasses the limit of eight

The Current Model of Islamic Banking 57

hundred million rupees of average profits, there is 30% more chance of

choosing participatory financing.

The regression results do not support the hypotheses of the study.

We assumed that strong firms will not do participatory financing with

Islamic Banks because it would not wish to share profit with Islamic

Banks. But the regression results do not support our conjecture. It

appears that strong firms do undertake the contract of participatory

financing with Islamic banks. One may ask about the probable reason of

this contradictory outcome. The possible reason is that Islamic Banks

might have invited strong firms for participatory financing by offering

them very attractive ratio in profit. We found some support in favour of

this explanation during our telephonic talk with authorities of various

firms. Another possible reason could be the diversification of financial

contracts with banks. A firm might keep financial relationship with both

Islamic and conventional banks. Hence, a firm might enter into financial

contracts with both types of banks. With Islamic banks they might be

involved in participatory financing, while with conventional banks in

interest-based financing.

6. CONCLUSION

Conventional financial system has failed in achieving the

objective of circulation of wealth with an economy. The reason is that

conventional financial system is based on interest which is the root cause

of the failure of circulation of wealth. Islam strictly prohibits interest and

encourages the circulation of wealth within an economy. The idea of

zakat and different types of charities (like sadqaat, fitrana on both Eids,

ushar etc.) shows that wealth should flow from rich towards poor people

in society. Islamic finance offers participatory mode of finance as an

alternative to ensure the circulation of wealth in an economy. This

mainly includes Mudharabah and Musharakah.

To achieve the objective of circulation of wealth Islamic banking

industry emerged in the world since 1963. However, the objective of

circulation of wealth has not been achieved even in Islamic countries.

What are the reasons of this failure? Many scholars have provided

58 Hassan and Shah

answers to this question including agency problems and strict

competition from conventional banks [Dar and Presely (2000); Febianto

and Kasri (2007)]. This work adds to such empirical literature. This

paper assumes that the motive of pursuing the objective of profit

maximisation is one of the main causes of failure in achieving the

objective of circulation of wealth. Consequently, Islamic banks mostly

adopt trade based non-risky modes of financing. This situation is against

the very purpose for which Islamic scholar were advocating the need of

Islamic economics and banking [Moudoodi (2000)].

The hypotheses of the paper are based on the assumption that

firms in the market are also maximiser of the profits. Hence, strong firms

are less likely to share their profit with Islamic Banks as compared to

weak firms, but weak firms have a high risk of loss, which the Islamic

Banks avoid by executing PLS contracts with them. The main reason of

preferring participatory financing by weak firm with Islamic Banks is

that they on average earn low profit hence will have to pay fewer

amounts to Islamic Banks. On the other side, if weak firms get loans

from conventional bank, they will have to pay fix amount even if it earns

low rate of profit.

The present study empirically explores the demand from firms

for participatory financing with Islamic Banks. The results reveal that

strong firms are involved in participatory financing with Islamic Banks.

Likewise, we find a positive and significant relationship between

average profits and participatory financing with Islamic Bank. On

average the findings provide weak support to the hypotheses of the study

as strong firms are doing participatory financing, while we assume that

strong firms are less likely to have participatory financing with Islamic

banks. However, the hypothesis is partially supported by the high level

of (54/63=85%) weak firms doing non-PLS financing with Islamic

banks.

The possible reasons for the weak support of the hypothesis

relating to strong firms are:

1) The motive of profit maximisation might force Islamic bank

to offer high rate of return to strong firms. Such offers benefit

Islamic Banks as it solves the issue of agency problem and moral

hazard. In addition, such offer provides Islamic Banks an

The Current Model of Islamic Banking 59

opportunity to develop a good relationship with such firms,

through which Islamic Banks can attract other strong firms from

the market. Over time such strong firms become loyal with

Islamic Banks and do not switch to other banks for a small

incentive.

2) Strong firms have branches all over the country and need

regular funding for their functions. A single bank cannot fund

them beyond a certain limit, hence in order to diversify they also

acquire PLS from Islamic banks. Moreover, they might demand

PLS for a sub-project with restricted profits while on average

their demand may be for non–PLS finance.

The findings need to be studied with caution. The reason is that

data on actual contract between firms and Islamic Banks is taken through

telephonic calls. In this regard those firms who avoided sharing

information are dropped from the analysis. Not dropping them could

make our result biased. Moreover, the information was collected from

finance or account section of the firms. While, the appropriate person to

reply this question is the owner or the key decision maker of a firm.

Likewise, the call receiver may have different projects in mind when

replying on phone to our question regarding participatory financing with

banks. While, we assume that participatory finance is for all projects of

the firms, we suggest future researchers to collect rich data and provide

answers of the question this study set out to examine.

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